February 02, 2009

More on international regulatory reform

Over at VoxEU.org, the debate on how to save the world continues. One of the best recent commentaries--by which I mean one that I wish I had written--comes from Katharina Pistor. The title says it all: "Reforming the Financial System: Beyond Standardization on “Best Practice” Models."

Most of the current approaches presume that we will have to have more financial regulation at the international level. This in turn presumes that there will be some convergence on what the "right" models of regulation are. As Katharina points out, this is neither necessary nor desirable.

The idea that effective market regulation can be achieved by standardizing rules and regulations on the most successful model at the time is deeply flawed for the following reasons. First, it treats legal institutions as endowments and ignores the need for maintenance and adaptation not only to local conditions, but also to future change. Second, it creates the illusion that a given market is institutionally sound and thereby disguises problems that may trigger future crises.

An alternative strategy to financial market regulation should make room for experimentation:

Experimentation with alternative regulatory approaches is more likely to produce solutions to new problems than standardizing rules on a single, but potentially flawed, model. Assessments of regulatory regimes could follow a “comply or explain” strategy as an alternative to benchmarking. Moreover, policy makers should play a greater role in disseminating alternative models and explaining their trade-offs rather than endorsing a single one.

The big question when you allow countries to adopt different regulatory regimes, and the one Katharina does not tackle, is how you prevent financial institutions from arbitraging these differences away by locating themselves and their activities in jurisdictions that impose the lowest immediate cost on their operations. In other words, can you run such systems without also allowing a certain amount of capital controls? I don't think so.

Comments

Hi Prof Rodrik,

And, another consideration is; who do you mitigate risk on malfeasant actors, who are more than willing to change the rules as they see fit--with this new and adaptable/changeable regulatory framework?

The collapse of the current American political system, or, "broken government", is a prime example on how a select few, can act together to stifle progress or engineer rewards for themselves.

This would, I am led to believe, would lead the market towards not only more instability, but also, put more economic power into the hands of politicians in a "broken" American government.

More realistic considerations must be taken into account with her article.

As sad as it sounds, we have to leave the market as it is, in regards to the regulatory framework--it is not inherently broken, but rather, needs an attitude check!

When I say attitude check, the market and guys like Rubin, Madoff and Thain, have to know that 1. Transparency is what matters and 2. We will follow up on theft!

This, is after a model for corporate governance, is, again, revised that makes the new model, force firms into to thinking about the society first and not for them, only, second.

Some call it Socialism, but if you want America to survive, or, any society for that matter, you have to take it serious!
Best,

Dani:
I would tend to think that Catherine Pister's comments have several other positives.

First, having different regulatory schemas in different countries, as opposed to a regulatory "monoculture" sounds like an excellent way to achieve a more compartmentalized economic structure that is inherently safer. Think of the analogies with natural systems, and how disease can and do run rampant in a monoculture.

Second, it is entirely possible that there exists regulatory schemes that work well only because of local conditions and would be very bad policies for another location. In that case, a consistent regulatory structure might only be able to be consistently BAD.

Third, regarding your concern of someone being able to somehow arbitrage the difference and thereby take advantage of this scheme of "a thousands flowers" of regulation, I suspect that you are right that some form of capital controls are needed but it is entirely possible that the necessary controls are inherent in the market structures that would arise should Catherine's comments be acted upon. The ability to arbitrage depends on some kind of external reference structure and supra-national and very liquid markets they have to be. Compartmentalize the topology, and arbitraging isn't so easy. In theory, one could have arbitraged the different regulatory environments in the 13th century for example, and made handsome profits selling nails in Greenland and Walrus Ivory in England but no one did, did they?

Another note: When Catherine says "The scale of the global crisis and its fallout for people around the globe calls for a new regulatory model. Rather than treating laws and regulations as fixed endowments that incorporate lessons from the past, a process-oriented strategy is needed that emphasizes continuous monitoring and adaptation of regulatory responses to changes in the market place." her reasoning gets just a little slippery--the responsiveness criteria is at odds with the diversification criteria, and present regulations do incorporate important lessons that shouldn't be forgotten (remember Glass-Steagall??I lot of people wish they did!) and therefore I'd say tread lightly with that responsiveness criteria....

It is in banks' interest to be associated with strict capital regulation. It helps market credibility, and--best of all--lets the strong bank play Fortinbras, and pick up the kingdom when there is blood on the floor. Ask the shareholders of Chase--proud owners of a cheap Bear Stearns and WaMu.

However, it is not in their managements' interest. A bank can only play Fortinbras once every decade or so: far beyond a typical CEO's tenure. They want quick profit now--best done with lax capital regulation.

This suggests yet another role for compensation regulation. There is much to be said for seven-year restricted stock, vested on the date of CEO retirement.

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